Economist, Telegraph Columnist, Broadcaster

Fears over US stimulus highlight Japan’s fragility

The Japanese economy is supposed to be recovering. Just a couple of weeks ago, official data indicated an expansion of 0.9pc during the first three months of this year. That placed the third-largest economy on earth among the developed world’s top-performers.

Here in the UK, our GDP increased by just 0.3pc during the first quarter of 2013, while the United States registered 0.6pc growth. The Eurozone, meanwhile, remained stuck in reverse gear, its economy contracting 0.2pc over the same period.

For most of 2012, Japan was caught in recession, its third spell in the economic doldrums since the onset of the financial crisis in 2008. During the final quarter of last year, though, growth returned, with Japan expanding by 0.3pc, before the recovery accelerated into the first quarter of this year.

Japanese industry has been leading the charge. Manufacturing, which still accounts for a fifth of all output, surged by 2.2pc during the first quarter, a stunning reversal from its 1.8pc contraction the quarter before. The sector has been helped, of course, by a falling currency. On a trade-weighted basis, the yen has shed 10pc of its value so far during 2013, as the Bank of Japan has cranked up its virtual printing press. That’s provided exports with a one-off boost.

Yet for all this good news, on Thursday the Nikkei-225 plunged by 7.3pc. This stomach-churning lurch in Japan’s main share index, its biggest one-day fall since the ghastly earthquake and tsunami of March 2011, is a body blow to global investor sentiment. By laying bare the fragility of one of the world’s major stock markets, this Nikkei nosedive directly challenges those who insist that the worst of the financial crisis is over and equity investors needn’t fear another systemic Lehman-style meltdown, with all the economic damage that would bring.

It’s true that the Nikkei was “due a correction”. Over the six months prior to this drop, Japanese shares had soared by a dizzying 71pc. The centre-piece of “Abenomics” – the policy creed of new Prime Minister Shinzo Abe – has been, and continues to be, the implementation of “quantitative easing” on a scale approaching that of the Bank of England and America’s Federal Reserve. That’s seen massive domestic liquidity injections flow into Japanese stocks, with a torrent of international “hot money”, or short-term investment flows, piling in behind them.

In the real world, of course, QE flows do little to raise productivity or enhance the long-term corporate earnings that are supposed to drive share prices. If anything, they promote the reverse. As such, Japan’s recent equity rally has been built on hot air – so was always bound to reverse.

This Nikkei’s pull-back coincided with survey data that suggest an imminent manufacturing slowdown in China – now Japan’s biggest trading partner. Some analysts were also concerned that recent volatility on Japanese bond markets means that Abe may soon be forced to go easy on QE.

For all these “local” explanations, though, the reality is that the timing of this move out of Japanese equity, which saw the Nikkei down as much as 12pc down in inter-day trading, had its origins in the States. This was a stampede made in America.

It’s not as if the US outlook isn’t improving. Just as in Japan, America’s real economy has lately been looking up. Consumer sentiment is close to a six-year high, according to the latest Thomson-Reuters survey, with more Americans feeling optimistic about their economic futures. That’s partly because the housing market is gaining momentum. Data released last week showed that in April, sales of previously-owned US homes rose to their highest level in three and a half years.

America’s labour market is also getting stronger. Unemployment is now at 7.3pc, its lowest level since December 2008. Business investment is also improving. US machinery orders rose 1.9pc in April, having previously fallen for two straight months, while commercial computer and electronics orders were up 3.6pc.

Yet news from the real world of commerce counts for little these days on global equity markets. Who cares if the biggest economy on the planet is showing signs of a genuine recovery? What really counts, in America as in Japan, is how much money the central bankers are printing.

Yes, the Nikkei was vulnerable after its recent surge. But the main reason Japanese stocks plunged on Thursday was that the day before, the US Federal Reserve had provoked considerable uncertainty about when it might start scaling back it own prolonged bout of money-printing.

America’s QE habit is currently stands at $85bn per month. Signs of a US recovery have sparked concerns that the Federal Reserve may soon start scaling back the “extraordinary measures”. This is all part of the “good news is bad news” irony of modern-day equity investing. If the economy gets a bit better, the QE bubble-blowing machine might be switched off, so causing a crash that returns us to the worst days of the credit crunch.

On Wednesday, the Fed delivered printed testimony pointing to a “weak” job market – code that QE will continue for the foreseeable future. But Chairman Ben Bernanke also disclosed that Fed money-printing, and the related bond purchases, could be scaled down “within the next few months”. On top of that, he also said “several” Fed governors might be willing to do this as early as next month. While the weight of money in the US market fended-off fears of declining QE, Japan’s recent rally meant the Nikkei was more brittle.

Eventually, of course, the Fed will have to start winding-down its money-printing antics. What last week’s Japan share rout showed is that even the slightest nod in this direction sends traders into panic mode – an outcome which, if sustained, could lead to rising interest rates plunging currencies and another “Minsky moment”. The strong likelihood is that withdrawal of these massive monetary stimuli isn’t going to be orderly. I wish that were not the case, but can anyone honestly examine last week events in Japan and argue otherwise?

For all these concerns about QE “cold turkey”, though, it remains my view that the most immediate threat to the relative calm on global markets remains the Eurozone. If anything, what happened on the Nikkei could convince the Fed and its political masters to prolong QE even further, and just suck up the consequences in terms of future inflation, higher commodity prices and diplomatic fall-out related to “currency wars”.

The Eurozone, though, remains in a perilously position. Ten months after European Central Bank Supremo Mario Draghi pledged to do “whatever it takes” to save monetary union, the entire structure remains in the balance. Draghi hinted last summer that it would purchases the sovereign bonds of big countries like Spain and Italy, if they got into serious difficulties. Germany’s Angela Merkel, at the time recumbent on her holiday sun-bed, didn’t directly contradict him.

That is the pinhead of stability upon which the stability of Europe’s sovereign bond market, and thus the entire monetary edifice, now rests. The eurocrats are hoping that relative tranquility can be maintained, that they can cling on, until Germany’s Federal elections in September – after which Merkel should have more bail-out latitude. That may work, or it may not.

The unwinding of “Abenomics” and the Fed’s upcoming QE-exit represent a serious threat to global investor sentiment. As we enter the dog days of summer, though, it may be an exploding eurozone that poses greater dangers still.